I guess my problem was not running Gnome3 - I was running a bare Xsession 
session with openbox window manager.
I logged out, then logged in with a Gnome3 Unity session, and update-manager is 
working OK for me
and downloading and applying changes. So for me the but is that update-manager 
does not work in
an Xsession (when I ran it there, I never got a password prompt for the sudo 
behavior).

(I still don't know why 'sudo apt-get update' failed as that should not
need any gui components)

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https://bugs.launchpad.net/bugs/819328

Title:
  [Oneiric] update-manager crashed with DBusException in _run():
  org.freedesktop.DBus.Error.NoReply: Did not receive a reply. Possible
  causes include: the remote application did not send a reply, the
  message bus security policy blocked the reply, the reply timeout
  expired, or the network connection was broken.

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